Quarter 3 2018

Investing on Emotional Urges is Playing the Loser’s Game

Headlines have been dominated by political arguments centered on a trade war along with news of rising interest rates from the Federal Reserve.  The nightly news and other media outlets are constant purveyors of the negative tidbits keeping investors either paralyzed from investing or motivated to exit the capital markets.  We have seen U.S. Equity funds and ETF’s experience net withdrawals of $41.3 billion, the most in a month since 2008.  February and March also constituted the very first two-month sequence of equity outflows since 2008.  Does this predict an anomaly, the start of a trend or signaling a bottom? *  The first emotional reaction many investors have is to use these unpredictable times to gravitate towards more active management.  They believe they should start to try and time the market.  Sell now before the market goes lower with the intention of buying back at a lower price.  Evidence has taught us this is a loser’s game.  Most active managers have historically underperformed the passive indexes which they try to outperform.  Active managers face constant pressure to perform on a quarter to quarter basis and tend to fall into the same biases which plague the individual investor.  They try to follow investor sentiment.  This is the time when we should rely on time tested factors which have had predictable results.  This is called Evidence based investing: Taking research and data to form investment decisions which are free from emotion.  This helps to mitigate the losses from active management and passive management.

Let’s examine the evidence.  For the first half of 2018 the market as represented by the S&P 500 had a positive return of 1.67%.  Looking deeper into this metric will give good insight as to the real performance of the overall stock market.

The first thing to notice of is more than a fourth of the S&P 500 is made up of the Information Technology sector (26.00%).  The Tech sector was up 10.17% for the first half of the year and without this sector the S&P 500 would have been down for the year.  The second emotional urge is to get involved in this sector to try and take advantage of outsized returns.  Evidence has shown this to also be a loser’s game. From 1998 through 1999 the tech sector enjoyed the same outperformance to the general market.  Then by the end of 2002 all the gains had been wiped away and it was not until 2013 that the five-year return of the Tech sector had once again surpassed market averages.   The Tech sector enjoys certain cyclical returns which outpace the market due to the riskiness of the sector. Unless you are willing to withstand long periods of underperformance to try and capture a few outsized returns this is not a sector to gamble with.

The second factor to examine is the returns of the Consumer Staples index.  This sector has historically been one of the safest sectors to invest.  The first half of the year performance of this sector was down -9.93%.  The third emotional urge is to sell the underperformance.  This urge is strongest among businessmen who are successful because they reward profits and punish losses.   This can be a catastrophic strategy when applied to stock investing.  This generally implies selling the lows and buying the highs.  The evidence shows the only sector which has not had negative returns over a five-year period since 1992 has been the Consumer Staples Sector.

There will be times when short term performance does not equal that of the overall stock market.  This is generally when the market performance is driven by the riskiest sectors of the market.  Time, patience and discipline will rule the day.  Adherence to the evidence and ignoring our inner biases will lead to successful investment returns.  In the words of Charlie Munger, “In the short run the market is a voting machine, in the long run the market is a weighing machine”.

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